Komputasi dan Pengetahuan Umum
Are you one of those investors who doesn’t look at how a company accounts for its inventory? For many companies, inventory represents a large (if not the largest) portion of assets and, as such, makes up an important part of the balance sheet. It is, therefore, crucial for investors who are analyzing stocks to understand how inventory is valued. (In times of economic distress and reduction in consumer spending, businesses always look for ways to increase profits. find out more, in Inventory Valuation For Investors: FIFO And LIFO.)
What is Inventory?
Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods.
The following equation expresses how a company’s inventory is determined:
|Beginning Inventory + Net Purchases – Cost of Goods Sold (COGS) = Ending Inventory|
In other words, you take what the company has in the beginning, add what it has purchased, subtract what’s been sold, and the result is what remains.
How do We Value Inventory?
The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet, income statement and statement of cash flow. There are three inventory-costing methods that are widely used by both public and private companies:
An important point in the examples above is that COGS appears on the income statement, while ending inventory appears on the balance sheet under current assets. (For more insight, see Reading The Balance Sheet.)
Why is Inventory Important?
If inflation were nonexistent, then all three of the inventory valuation methods would produce the exact same results. When prices are stable, our bakery would be able to produce all of its loafs of bread at $1, and FIFO, LIFO and average cost would give us a cost of $1 per loaf.
Unfortunately, the world is more complicated. Over the long term, prices tend to rise, which means the choice of accounting method can dramatically affect valuation ratios.
If prices are rising, each of the accounting methods produce the following results:
(Note: if prices are decreasing, then the complete opposite of the above is true.)
One thing to keep in mind is that companies are prevented from getting the best of both worlds. If a company uses LIFO valuation when it files taxes, which results in lower taxes when prices are increasing, it then must also use LIFO when it reports financial results to shareholders. This lowers net income and, ultimately, earnings per share. (Cash-value life insurance has always provided consumers with a tax-free avenue of growth within the policy that could be accessed at any time, for any reason. Find out more, in Insurance: Avoiding The Modified Endowment Contract Trap.)
Let’s examine the inventory of Cory’s Tequila Co. (CTC) to see how the different inventory valuation methods can affect the financial analysis of a company.
|Monthly Inventory Purchases*|
|Month||Units Purchased||Cost/ea||Total Value|
|Beginning Inventory = 1,000 units purchased at $8 each (a total of 4,000 units)|
|Income Statement (simplified): January-March*|
|Sales = 3,000 units @ $20 each||$60,000||$60,000||$60,000|
|Ending Inventory (appears on B/S)
*See calculation below
|*Note: All calculations assume that there are 1,000 units left for ending inventory:
(4,000 units – 3,000 units sold = 1,000 units left)
What we are doing here is figuring out the ending inventory, the results of which depend on the accounting method, in order to find out what COGS is. All we’ve done is rearrange the above equation into the following:
|Beginning Inventory + Net Purchases – Ending Inventory = Cost of Goods Sold|
Inventory Cost =
|1,000 units X $8 each = $8,000|
|Remember that the last units in are sold first; therefore, we leave the oldest units for ending inventory.|
Inventory Cost =
|1,000 units X $15 each = $15,000|
|Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.|
|Average Cost Ending Inventory =||[(1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = $11.25 per unit
1,000 units X $11.25 each = $11,250
|Remember that we take a weighted average of all the units in inventory.|
Using the information above, we can calculate various performance and leverage ratios. Let’s assume the following:
|Assets (not including inventory)||$150,000|
|Current assets (not including inventory)||$100,000|
Each inventory valuation method causes the various ratios to produce significantly different results (excluding the effects of income taxes):
|Gross Profit Margin||38%||50%||44%|
To learn more about each ratio listed above, see the Ratio Analysis Tutorial.
As you can see from the ratio results, inventory analysis can have a big effect on the bottom line. Unfortunately, a company probably won’t publish its entire inventory situation in its financial statements. Companies are required, however, to state in the notes to financial statements what inventory system they use. By learning how these differences work, you will be better able to compare companies within the same industry.
Many companies will also state that they use the “lower of cost or market.” This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of FIFO, LIFO or average cost.
Understanding inventory calculation might seem overwhelming, but it’s something you need to be aware of. Next time you’re valuing a company, check out its inventory; it might reveal more than you thought.